How Options Work: The Basics
Options work by creating a contract between a buyer and a seller. The buyer pays a premium to acquire a right: the right to buy shares (call option) or sell shares (put option) at a fixed price (strike price) before a deadline (expiration date). The seller receives the premium and takes on an obligation: to sell shares if a call is exercised or buy shares if a put is exercised.
The beauty of options is that buyers have rights with limited risk (they can only lose the premium), while sellers have obligations with limited profit (they can only keep the premium). This asymmetry is what makes options so versatile: buyers get leverage with defined risk, and sellers earn income by accepting risk.
Every option trade involves a transfer of risk. The buyer pays the seller a premium in exchange for the seller taking on risk. It works like insurance: the premium buyer gets peace of mind (or speculative opportunity), and the premium seller earns income for accepting the possibility of a payout.
Step 1: How Option Prices Are Set
Option prices (premiums) are determined by supply and demand in the marketplace, but they closely track theoretical values calculated by pricing models. The Black-Scholes model and binomial models are the most widely used. These models consider six factors: the current stock price, strike price, time to expiration, volatility (expected price fluctuations), risk-free interest rate, and dividends.
Step 2: How You Buy and Sell Options
Placing an Options Trade
Step 3: How Options Move in Price
| Factor | Effect on Calls | Effect on Puts | Measured By |
|---|---|---|---|
| Stock price rises | Price increases | Price decreases | Delta |
| Stock price falls | Price decreases | Price increases | Delta |
| Time passes | Price decreases | Price decreases | Theta |
| Volatility rises | Price increases | Price increases | Vega |
| Volatility falls | Price decreases | Price decreases | Vega |
Step 4: How Expiration and Exercise Work
At expiration, options are either in the money (ITM) or out of the money (OTM). ITM options are auto-exercised by the Options Clearing Corporation (OCC) if they are ITM by $0.01 or more. Call exercise results in buying 100 shares at the strike price. Put exercise results in selling 100 shares at the strike price. OTM options expire worthless, and no shares change hands.
- 1Day 1: Buy 1 call for $300 total ($3.00 × 100)
- 2Day 10: Stock rises to $108. Call now worth ~$5.50. Unrealized profit: $250
- 3Day 20: Stock pulls back to $103. Call worth ~$2.00. Unrealized loss: $100
- 4Day 28: Stock rallies to $115. Call worth ~$10.50. Unrealized profit: $750
- 5Day 30 (expiration): Stock at $115. Call exercised, buy 100 shares at $105
- 6Sell shares at $115: Gross = $11,500 - $10,500 - $300 = $700 profit
- 7Alternative: Sell call before expiry for $10.50 × 100 = $1,050. Profit = $750 (better due to time value)
How Time Decay Works
Time decay is the daily erosion of an option's time value. It accelerates as expiration approaches, following a square-root-of-time relationship. An option with 60 days left might lose $0.03 per day to theta, while the same option with 7 days left might lose $0.15 per day. This is why most option buyers aim to close positions well before expiration, and most option sellers prefer short-dated contracts where decay is fastest.
How Assignment Works for Sellers
If you sell an option, you may be assigned at any time (American-style options). Assignment means you must fulfill the obligation: sell shares at the strike (if assigned on a call) or buy shares at the strike (if assigned on a put). Assignment is most likely near expiration when options are ITM, or before an ex-dividend date for calls. Your broker handles the mechanics, but you need sufficient account equity.
Options are wasting assets. Unlike stocks, which can be held indefinitely, options lose value every day through time decay and eventually expire. This time pressure is the fundamental difference between options and stock trading. Always factor in the time dimension.
